AB Analytical Services

General Electric: Not a Value Trap, but a Value Pit

This weekend, Barron's published its annual market prediction survey (subscription required) open to its readers.  #11 is always a tough one for me: Which Dow Jones Industrial Average member will perform the worst in the coming year?  I said JP Morgan last year, and it wasn't even close.  The biggest loser was American International Group (AIG), which was booted and is down 97%.  Of the remaining DJIA members, General Motors (GM), not surprisingly, is down the most.  At least I did better on my pick for the best one, Johnson & Johnson (JNJ), which should end the year in 3rd or 4th place.

I don't spend a lot of time or effort analyzing large companies, but it is important to have a feel for their prospects due to their large contribution to the broad markets in terms of market capitalization as well as economic impact.  While 2008 was a year that saw the demise of one "general" (GM), which actually was my pick for the Barron's contest due to my expectation that the equity gets totally wiped out, 2009's most devastating loss could come from its other "general", General Electic (GE).

GE didn't exactly have a great year this year, as it is down almost 57% despite an infusion from Warren Buffet.  It has actually been a while since GE had a good year, as it has declined in each of the three previous years as well, underperforming the S&P 500 quite substantially along the way, especially this year (its first double-digit negative relative performance, most of which has transpired in just this quarter).  From a big picture perspective, GE, the traditional epitome of earnings stability, hinted at serious underlying challenges in the summer, when it missed.  Analysts and investors, who for years have sought more disclosure regarding the massive GE Capital unit, began to question a little harder.  GE then surprised the market by selling stock into a huge down bid, and it has suffered since then.  While the stock has bounced, it hasn't made up much of the losses relative to Industrials in general, trading more like a Financial.  Relative to the broad market, the stock sits near its lows, as you can see in the chart below.

You might look at the chart and conclude quickly that GE is extremely cheap.  After all, the price hasn't been this low since 1997, it has underperformed the rest of the market rather substantially since the 2000 peak (and is back to 1995 relative levels), its PE bounced off of a 20-year low and its P/B is the lowest it has been in decades (and close to the magic 1X).  No one has been showing this company any love!

In a bull market, when you try to play "mean-reversion", you can get stuck in a value trap.  The stock is cheap for a reason and fails to participate in a rally.  In a bear market, though, you can fall into a value pit.  Every single failed financial was cheap and lauded as such before it was wiped out.  Ask Bill Miller, Rich Pzena or practically any investor in Financials over the past year.  I even confess to succumbing to the siren's call for the GSEs.  

So, why do I think that GE might actually be more of a "pit" than a "trap"?  Last week, I warned investors to steer clear of companies with "big bad balance sheets", briefly citing GE as an example.  The balance sheet is horrible, and faith in the company is rapidly waning.  As I will highlight below, they have a ton of debt, much of it short-term.  They had attempted to sell some assets, but they suspended those efforts.  Perhaps my thesis is too simple, that this massively leveraged company could struggle with liquidity, but take a look at the chart below to get a less rosy view of this great American icon:

While many may believe that "GE is worth less today than it was over a decade ago", it's simply not true.  The equity value certainly has declined, but the enterprise value, which adds the net debt, has increased dramatically and isn't too far from its all-time peak in 2000.  Make no mistake:  GE has continued to party like it's 1999 until very recently, when it found its new religion (shrinking GE Capital).  Now the debt-holders control a much larger piece of the pie than the equity-holders.  As you can see above, this massive expansion of the balance sheet has hurt the return on capital while keeping return on equity at a high-double digit level.  Here is what the balance sheet transformation looks like:

 

Note that these numbers precede both the equity sale as well as the preferred sale, so the liquidity is better than it appears.  Still, though, the rapid expansion of GE Capital is quite evident, and it leaves the company with little flexibility in any downside scenario.  Tangible equity is now dwarfed by its overall debt burden (share repurchases at high prices as well as acquistions).  GE's industrial business, which is global in nature and extremely diversifed, should ordinarily weather isolated storms well, but this is no ordinary storm.  Even without the potential credit problems from GE Capital, the core business should struggle.  The weak balance sheet takes flexibility away from the company - no share repurchases, perhaps a slashed dividend (despite their maintaining otherwise), inability to potentially take advantage of other asset sales, etc. 

It's no wonder that the company has been so aggressive in raising capital lately.  The rating agencies, just slightly behind the eight-ball, have finally figured out that perhaps GE isn't really AAA quality.  Weak fundamentals, pressure from the balance sheet, and challenging capital markets could make 2009 yet another year that GE shareholders will want to forget. 

Disclosure:  No position in GE

Big Bad Balance Sheets: Buyers Beware

As I mentioned in a recent article, the changing environment will most likely demand changing valuation metrics.  As companies likely begin to generate losses or at least substantially lower earnings as the economy deteriorates in a manner unprecedented in most of our lives, the popular PE ratio will likely prove to be rather useless.  Many commentators, including myself, have noted how many stocks now trade at "book value" or less, but this valuation exercise is too simplistic:  It ignores high levels of intangibles and goodwill, overvalued inventory, difficult to collect receivables and hard to liquidate plant, property and equipment in a deflationary environment.  While I believe that there will be a greater focus on price to tangible book value, that metric alone won't suffice.  Investors will have to incorporate true leverage of the enterprise as well.

What do I mean by "true leverage"?  In very simple terms, the balance sheet consists of two main components:  Assets and Liabilites.  In a deflationary environment, different types of assets have more significance than others.  I don't even pretend to have an easy way to grade in absolute terms the different components, but we know that in tough times cash is good and goodwill isn't.  As I mentioned above, goodwill is worthless, while inventory, receivables and fixed-assets are worth less.  Even cash, though, can be challenging.  Is it invested in auction-rate securities (ARS)?  Worse, is it stuck offshore?  I think that many of these distinctions will be analyzed to a greater degree when trying to differentiate between companies.

On the liablity side, though, I believe that all of us investors will need to gain a better understanding of those obligations.  While short-term and long-term debt are easily recognized and included in fundamental and quantitative analysis, what about other types of liabilities?  My thesis is that investors will have to focus more on Total Liabilites, which includes a lot more than debt.  Often a company can appear to be "debt-free", yet it has collected unbooked sales, which are a liability.  Deferred Revenue, which offsets cash on the left side of the balance sheet, must be reduced over time by sales.  In other words, the balance sheet's assets have been strengthened by tomorrow's delivery of goods and services.  I am not an accounting expert and didn't even take a class in college (though I sure have spent a lot of time reading and learning from the CFA program and beyond), but it is clear to me that there are many, many types of liabilities that go beyond debt.  Just take a look at the General Motors (GM) balance sheet to see what I mean.

I plan to spend a great deal of time trying to find "overleveraged" non-financial companies, as I expect that many of them will experience an even more significant downturn in 2009 than they did in 2008.  My thesis is that companies with large financial obligations (total liabilities) will struggle to meet them as the economy declines.  In the past, it hasn't been a problem, as many of these companies just "rolled over" their obligations as they became due.  No longer is it this simple, as capital is being constrained.  Companies can use cashflow, but it will likely diminish as the economy retreats.  Selling assets could help, but that method could also face challenges as the likely buyers could be inundated by the sellers.  A final method is to sell stock, and this is one that may become increasingly prevalent despite depressed prices.  In this type of environment, it is the equity holder who will lose.

In future articles, I hope to highlight specific companies that should be avoided, but I believe that the reader can probably identify some obvious candidates rather quickly, like General Electric (GE).  The recent ratings agencies warning about their AAA credit should come as no surprise (neither the action nor the fact that it is so late).  With over $700 billion in total liabilities ($219 billion of which is short-term debt) and almost no tangible equity, one would expect to see asset sales (they suspended their attempt).  One that seems not-so-obvious is ATT (T).  Similar to many of its peers who compete in a brutal industry that could see intense pricing pressure, they have quite the bloated balance sheet.  With a PE of 10 and a P/B ratio of 1.5, it sure looks cheap, right?  The equity is valued at $165 billion, which towers over its tangible book value (-$22 billion).  The company has $172 billion in total liabilities, including over $15.8 billion that must be rolled over this year (as of 9/30), net of cash. Its current ratio (short assets to short liabilities) is about 50%.  The stock is down less than the market this year but has one of the largest debt-rollovers outside of the Financial sector.

As I said, this article focuses less on names and more on the big picture.  According to my data source, StockVal, the S&P 500 companies have a cumulative market capitalization of over $8 trillion.  The group of companies has total liabilities of approximately $22 trillion.  In other words, what these companies owe is a lot more than the value their current owners enjoy.  The various economic sectors, though, have vastly different profiles, with the bulk of the leverage confined to the Financial sector.  Stripping that sector out, stocks currently worth about $7 trillion have total liabilities of $6 trillion.

In and of itself, I am not sure that there is any problem with having high financial obligations relative to the "worth" of a company, but, as we can see below, different sectors have vastly different ratios.  Further, within different sectors, some companies appear to have fed at the trough a bit too long.  Servicing costs for debt have been relatively low over the past many years due to cheap money.  With access to capital shrinking and the cost rising except to those who either don't need to borrow or are the U.S. Treasury, the amount of debt and other financial obligations could become a burden.  I believe that investors will be rewarded for avoiding those companies that could run into trouble.  For starters, though, what are some of the key metrics for the various sectors of the S&P 500?

I have attempted to put the total financial obligations of the various economic sectors into context.  The first two ratios compare total liabilities and short-term debt to market value.  In an economy that could cause an inability to realize asset values via earnings or liquidation, equity sales could become more necessary.  If it's not there, watch out!  The next two ratios compare total liabilities to trailing EBITDA (which should come under pressure) and to current assets.  These ratios help us get a sense on who might actually have to sell stock.  The next ratio, tangible equity (which excludes goodwill) to total assets, gives us a sense of who has cash or hard assets that can be used to fulfill obligations.  Finally, I included traditional valuation ratios that I expect to become increasingly less helpful.

As I review the table, it is clear that the Financial sector is still very leveraged, though this isn't too surprising.  Many proponents of the Tech sector have correctly pointed to the strong balance sheets, and it certainly is apparent in the graphic.  While Healthcare companies typically carry more goodwill, the overall metrics look favorable.  In a surprise to me, Energy looks quite healthy on a relative basis, though the balance sheets tend to be weighted less towards current assets than long-term ones (and those reserves aren't gaining value).  Materials aren't as solid as Energy companies, but the sector appears to have better than typical characteristics generally.  Industrials look ripe for further investigation, as clearly several companies are stinking up the joint (beyond GE).  Similarly, Consumer Discretionary looks to contain several potential landmines.  Two sectors that look unfavorable but probably aren't as bad as they seem are Consumer Staples and Utilities.  The cashflows tend to be more stable and thus the reliance upon balance sheet metrics should be limited (hopefully).  Finally, an area that is downright frightening to me is the Telecommunication Services - it's not just T.  My discussions with clients and peers leads me to believe that the market is potentially turning away from absolutely horrible balance sheet metrics due to a perception of stable cashflows and easy access to the capital markets.  In any event, there is variation among the components of each of these sectors, though some of the sectors in general stand out positively or negatively.

The Bear Market's first leg down hurt mainly Financials and many cyclicals, while the second leg down (September on) has been very indiscriminant.  I anticipate that the next leg down will prove extremely harmful to companies with "too much leverage".  While we are all familiar with the high leverage in the Financial sector, I believe that investors will be well served to try to differentiate between companies in other sectors.  In an environment that will be tough on operating cash flow as well as realizations from asset sales, we could see many companies forced to sell equity to meet short-term obligations.  While I have given this overall concept considerable thought over the past couple of weeks, I think that my efforts are only a start.  I hope that my thoughts provoke others (hopefully with better accounting backgrounds than I have!) to start looking at companies beyond simplistic ratios.  Haircutting assets, projecting cashflows, understanding the nature of and the timing of financial liabilities (i.e. beyond just "debt") and predicting the timing of equity issuance will allow the stock investor to avoid some of what could be more damage from this economic downturn.

Disclosure:  No position in stocks mentioned.

Is Your Stock A Zombie?

Many have used the term "zombie" to describe certain financial institutions with questionable assets and overwhelming liabilities, essentially insolvent banks that continue to live on despite their permanently impaired position.  As I ponder the potential for a year of negative GDP (nominal) in 2009, something we haven't experienced in my lifetime of 44 years, I wonder by what process the market will soon begin to value companies that have low or no earnings.  While I am aware that many investors discuss the concept of "earnings power", the challenge will be to incorporate margins and costs of capital that might be quite different from the past decade in the event we are in a protracted period of slow or negative growth.  In other words, the last 18 years or so have seen relatively steady and somewhat strong real growth and a massive expansion of debt. 

If the economy shrinks in 2009 and earnings implode, I believe that investors will migrate to valuation techniques that incorporate book value.  I have written about how many of the S&P 500 companies trade "below book value"  (151 currently) and shared the pitfalls with that metric:  Lots of goodwill or intangibles, bloated inventories, overvalued factories, equipment and land and uncollectable receivables can render that metric unreliable at best.  Even using "price to tangible book" suffers from asset quality issues, so investors will have to dig a little deeper and discount, if necessary, certain components of the balance sheet.

In the environment that I am describing, investors will avoid companies who are burdened by high levels of debt (or other liabilities that are claims on assets) and whose market value is high relative to the value of the underlying net assets, especially in competitive industries that could endure price wars.  We could see the term "zombie" applied to non-financials that have high levels of debt, especially if it is due within 3 years.  

While it is one task to identify a zombie, the more important job is to identify an expensive one, as it isn't likely to fare well at all in a prolonged recession with limited capital.  There is no exact delineation for "too much" debt.  As I mentioned before, sometimes liabilities aren't classified as debt, so we need to include them.  Also, it makes sense to adjust liabilities by crediting the company for cash.  In my screening of the S&P 500 for potential zombies, I have created a new metric that I hope allows the quick identification of companies that could be at risk:  Tangible Leverage.  Here is the definition:

(Total Assets less Goodwill/Intangibles) / (Common Equity less Goodwill/Intangibles)

What I have attempted to do is determine a "lights-out" ratio for valuing a company that strips intangibles from the balance sheet.  While it is a rather harsh way to look at a company, I expect that increasingly investors will discount intangibles and goodwill.  The goal, then, is to identify companies with high Liabilities (Assets less Equity) relative to the "worth" of the companies.  These are the companies that could face problems rolling over their debt.

The table below on the S&P 500 Industrials includes this ratio.  Note that interpreting the ratio is not as simple as I would like it to be, as 1.0 is a great number (all assets, zero liabilities).  Negative numbers imply no tangible equity (and perhaps no equity either), while "high" numbers would imply a lot of debt.  I don't know how high is too high, but I have highlighted all of those that are negative or greater than 5.  This ratio gives the investor a measure of risk, while the "price to tangible book" gives investors a measure of value.  All things equal (they never are!), one would expect that the riskier the company in this environment, the closer the stock would be priced to its tangible book value.  As you can see, that isn't necessarily the case.

   

The stocks are ranked by traditional leverage, so the ones at the top have low financial leverage (Assets/Equity) relative to the ones at the bottom, though note that the first one has negative equity and should thus be at the bottom of the list.  I have highlighted the adjusted ratio that I described above in cases where it is negative or above 5 (arbitrary).  I have also highlighted high P/TB ratios as well as a few other metrics, including high levels of short-term debt, high debt-to-capital (the negative numbers indicate more cash than debt) as well as a few PE ratios that seem high. 

So, how can we use this information?  As I stated before, companies with high levels of debt, lots of intangibles and a high price/tangible book ratio could be very vulnerable to a protracted downturn.  While the last 6 companies have high traditional leverage ratios (all above 5), their adjusted leverage ratios are in cases substantially higher.  While the traditional Price/Book ratio ranges from 1 to 13, Pitney Bowes (PBI)  actually has a negative Price/Tangible Book ratio.  The other 5 range from 2x to 12X.

There are some real surprises, though, as one looks at companies that theoretically don't have so much leverage.  While I haven't done any work on these, consider the following:

• Eaton (ETN):  2.6X Leverage, 39% net debt to capital, 1.1X BV and 7 PE
• Emerson (EMR): 2.3X Leverage, 22% net debt to capital, 2.7X BV and 11 PE
• ITT (ITT):  3X Leverage, 24% net debt to capital, 1.8X BV and 10 PE

By traditional metrics, these three stocks appear to be cheap on a PE and BV basis (historically and compared to the entire sector) and have "average" leverage and net debt to capital for the entire Industrial sector.  By excluding intangibles, though, we see an entirely different picture, as ETN has negative tangible equity (and $1.4 billion of short-term debt to roll), EMR has an adjusted leverage ratio of 8X and a P/TB of 14X, and ITT has negative tangible equity (with $1.7 billion of short-term debt to roll).  While the market seems to be on to ETN looking like a zombie, I wonder if investors in EMR or ITT look at the company that way.  If the companies have any problems addressing liquidity issues, they could be forced to sell equity into a market that isn't exactly embracing stock issuance.  Additionally, as companies will most likely be writing down intangibles, the low P/B ratios will rise, removing what could be an artificial valuation floor. 

FedEx (FDX), on the other hand, has an above average PE (13.6X), but it has little net debt, low leverage (1.8X, 2.0X adjusted for intangibles) and a modest P/B and P/TB ratio.  Contrast that with United Parcel Service (UPS), which is down slightly less in 2008.  The PE is slightly higher (14.7X), and the leverage ratios and P/B and P/TB are all higher.  Grainger (GWW) and Precision Castparts (PCP) stand out as relatively low valuation and strong balance sheet.

This discussion isn't intended to suggest that you buy or sell any of the stocks mentioned, but rather it serves to introduce or elaborate upon a metric that I expect to become increasingly popular in this unchartered territory we find ourselves.  2008 has seen stocks sold off en masse, with little differentiation.  As the credit crunch continues into 2009, I would expect to see less reliance upon PE and more of a reliance upon balance sheet related valuation metrics.  While I shared examples from large-cap Industrials, this type of analysis applies to all sectors and to all market capitalizations.  Until credit is more readily available, it is wise to avoid potential zombies.

Disclosure:  Long CTAS and long CTAS and ITW in one or more of my model portfolios

We Can't "Spend and Save" Our Way Out of the Recession

The news media reported the stunning decline in Household Debt last week, but they missed one of the key elements.  While it is true that consumers saw the first quarterly decline in the level of debt in the history of the data series, it wasn't because people were paying down debt.  Instead, the cause of the decline was mortgage defaults, where the debt is wiped out by transfer to the bank.  No, it's not exactly like consumers, on balance, are paying down their debts.  The overall growth in Household Debt (primarily mortgage and consumer debt) is stunning:

 

It is more fair to show the long-term history in terms of annual growth rates, which are still concerning:

  

We have enjoyed a period of accelerating and high growth in mortgage and consumer debt for many years, but it is now falling off a cliff.

The underlying data is available in the Federal Reserve's "Flow of Funds Accounts of the United States", most recently updated through Q3.  This provides a great historical refererence for all the sectors of our economy.  While it is true that Household Debt fell from the previous quarter by $40 billion to roughly $13.91 trillion, it still rose $300 billion from a year ago.  Interestingly, though, the overall indebtedness of our country (citizens, corporations and governments) increased by almost $600 billion from the prior quarter and by $1.9 trillion (6%) from a year ago.  The main culprits:  Federal Government and the Financial sectors. 

Many financial pundits declared that consumers are adjusting to the current economic downturn, which is now true, but it wasn't really captured in the recently released data.  Given what I have read about the recent moves by the credit card industry (jacking rates, slashing limits) as well as the overall shrinkage of the availability of other types of consumer loans (education, auto, installment), we are probably going to soon see an annual decline in Household Debt. Here is the complete breakdown of total debt outstanding:

 While it seems clear that we should expect to see continued heavy growth in government debt, especially on the federal levels, it should not surprise anyone to see all of the other sectors experience total debt decline (isn't that what we mean by deleveraging). 

The amount of debt outstanding can be compared to incomes (which, in aggregate, should be falling soon), GDP or net worth.  Net worth can be easily calculated (apparently) by the government for certain sectors, but what is the net worth of the U.S. Federal Government?  I have never seen a balance sheet!  While the amount of debt at the Household level fell, it should be noted that the Household Net Worth plunged by multiples of that small decline (stocks and houses were the obvious culprits).

I have been struggling with how we will eventually emerge from this morass, and I am more worried than ever.  It seems clear to me that we can't spend any longer to buy our way out, as consumer credit and the housing piggy bank have all but shut down.  It also seems clear to me that savings will be going up as well.  Is the federal government big enough to absorb the restructuring of the balance sheets of households, businesses, state & local governments and financial institutions?  Probably not.  We risk higher taxes and higher interest rates, which could contribute to years and years of slow economic growth (or a shorter period of utter chaos). 

I believe that we could see very negative Real GDP (and potentially nominal as well) over the next year (like -5%).  In the past three months, retail spending, which is just a subset of overall consumer spending, has declined at an astounding annualized rate of about 25%.  Stripping out autos, which allows me to share a chart with a longer history as well as remove a major swing factor, we have seen an off-the-charts decline that has eclipsed even post-9/11. 

 

While I was extremely negative in late 2007, I was premature in becoming more optimistic as 2008 progressed.  Clearly, I am not a "permabear", but I find myself more negative today than I was in advance of the mestasis of the "cancer" from just sub-prime to mortgages in general last year.  We now have a full-blown late-stage "cancer", and the radiation and chemo this economy will need (massive government intervention like we have never seen) could leave us crippled for years to come.  As long as we need to simultaneously spend as well as save, stocks are likely to be a losing proposition.  Years from now, when interest rates are substantially higher and balance sheets are repaired, the next bull market will emerge.  Until then, expect low PE ratios (for now, as earnings decline), weak fundamentals and continued pressure from outflows.  There is no quick fix, which is ironic, since the quick-fix allure of debt to propel a slowing economy was the genesis of this crisis.

Disclosure:  None

Investing in Stocks in a Deleveraging Economy

Like any of you who agree with me that the economy is going to be significantly challenged for quite some time, I struggle with how to invest (if at all).  If you don't agree with me, then this article is not likely to be useful to you. If you too believe that we are likely to confront headwinds like we have never experienced, you might appreciate some of these ideas on coping with the environment. 

I used the rally last week to raise a lot of cash as well as to reduce exposure in my Conservative Growth/Balanced model portfolio to 56% stocks compared to a neutral 60%.  While the market remains oversold and could appreciate more, I am trying to position the portfolio to better reflect the fundamentals subsequent to the Wile E. Coyote falling off the cliff back in late September.  If you don't remember that Looney Tunes battle, here is a great reminder.  I am disappointed that it took me way too long to realize where we were after having been so bearish in the summer of 2007, but the rest of this article reflects the views I shared several weeks ago.  I believe that the market has started to behave more rationally recently, with better two-way flow and better discrimination among the individual stocks, so this is actually a good time to restructure portfolios and reduce exposure to stocks or other investments that no longer make sense.

The first order of business is to get the overall exposure to risky assets in line.  While "zero" may very well be the right number, it can be impossible (guidelines if you are a fiduciary) or too risky (if you are wrong).  In an economy that is starved for credit, realize that any asset, even "risk-free" Treasuries are vulnerable to sale.  While stocks, corporate and asset-backed bonds, many commodities and tangibles such as art have certainly demonstrated this vulnerability, commercial real estate too should soon show dramatic weakness.  Some stocks will certainly go up as the companies might be in a position to actually benefit or at least be unaffected by the recession or may benefit from rotation by investors who have to hold some stocks (the least worst), the vast majority will be cheap and get cheaper as long as leverage is contracting throughout the economy.  So, the answer to "how much" is "as little as possible".

If one accepts that the path of stocks is likely lower but has to hold some stocks, I suggest the following:

• Invest in companies with strong balance sheets but low valuations
• Try to identify potential beneficiaries
• Be willing to trade

I have been emphasizing high quality stocks since I began writing on Seeking Alpha in early 2007.  In an environment where future earnings are so suspect, investors have increasingly been turning to different types of valuation.  While many use "Price to Book", I prefer to strip out intangibles and the goodwill accumulated via acquisitions and focus on price to "tangible book value", which is more conservative.  Since asset prices are in general decline, though, one has to pay special attention to the composition of the assets on the balance sheet.  Is the inventory correctly valued?  Are the receivables actually collectable?  Is the carrying price of factories, equipment and property realistic in a liquidation?  Avoid companies with a lot of debt (a lot might be ANY debt), especially short-term debt in excess of cash.  The company could be forced to sell stock or to shed assets below carrying cost to cover debt maturities.  Finally, be especially wary of companies that have unsustainably high dividends.

I have shared a few themes of possible beneficiaries of the shrinking economy.  Make no mistake:  In an economy that is 70% related to consumer spending, GDP will most likely be contracting like we haven't seen.  Retail sales have fallen at an annualized rate of 25% over the past three months.  Even stripping out autos, which certainly removes one of the major drags and also allows my data to go back further, the annualized rate of decline has exceeded 18%:

View this photo

Not only was is this decline unprecedented in my life-time (44 years), the rapid decline, literally off-the-chart in the middle panel, well eclipses the hit we took after 9/11.  With the consumer accounting for so much of the economy, it is likely, in my opinion, that we will suffer perhaps the worst annual decline in Real GDP in my lifetime as well (almost -3% in the early 80s).  Nominal GDP could actually come in negative for 2009:  Consumer should decline greatly, business capital spending will plunge, and net exports should be a drag.  The government sector, which accounts for about 20% of the economy, can't grow fast enough to offset these hits.  Most companies will see falling revenues and even sharper drops in earnings as profit margins are squeezed. 

I have written about several sectors that are of interest to me:  pawn shops (like EZCORP (EZPW) or other providers of credit outside of the traditional credit card or retail lending industry (like America's Car-Mart (CRMT), auto repair stores, and food processors (like Hormel (HRL)).  I think that another area might be security-related firms, whether its burglar alarms, guns or Tasers.  Finally, unfortunately, we might have geopolitical unrest, which would suggest investing in companies that help provide national defense.  In a bad neighborhood, some of these types of companies could be the best houses on the block.  The three stocks above are among my largest holdings.  Another large holding is a PBM, Catalyst Health Solutions, formerly HealthExtras (CHSI). I don't view this as a beneficiary, but rather one that might not be impacted too badly.

Finally, in a wild and crazy market, we should let volatility be our friend.  If there is sudden demand for one of my stocks that I think is an overreaction to short-term news, I just sell it, or at least a substantial portion of it.  Likewise, when a stock that meets my criteria for safety in terms of balance sheet is signficantly oversold for what I view as a temporary issue, I buy it.  These wild gyrations in the market have allowed me to add to returns.  It is important to be willing in a bear market to sell so that we have cash to buy later.  Never has "trading" in the context of a long-term portfolio been as potentially lucrative as it is now.  With hedge funds losing assets rapidly and scaling back bets as well, one of the market's most notorious liquidity providers has become a fraction of its former self.  I could offer many examples, but one that I would like to share is Astec Industries (ASTE).  I added to my position at the time when it traded below 18 (in utter disbelief).  I scaled out on the way up and closed out my position at 30.86 amidst the crowd chasing "infrastructure" plays.  While I lament not getting that last point or two, I was able to redeploy the proceeds into another extremely oversold issue at the time (not too hard to find these days).

So, cutting exposure, really focusing on absolute safety by emphasizing a strong balance sheet, a willingness to trade more opportunistically and pursuing a few themes that don't seem to be on everyone's radar yet are some of the steps I am taking to cope with this environment.  I welcome any other ideas!

Disclosure:  Long EZPW, CRMT, CHSI and HRL

If You Own Gold, It's Time to Fold

I first addressed my negative views on gold in mid-October, and boy was that a learning experience.  I had known the definition of "gold bug", but I was totally unaware of its antonym until I reviewed the 100+ almost exclusively negative comments that article generated.  Apparently, the term used most frequently to describe someone who doesn't ascribe to the cult of Gold is "idiot".  I also learned of all sorts of conspiracy theories and the difference between "real gold" and "paper gold".  I will simplify that as the difference between what Joe Retail is willing to pay so that he can get his hands on his investment vs. the much larger futures market.

I am not here today to gloat despite the fact that gold has plunged since I wrote that article on October 11th.  I have given considerable thought to not only gold but also to the more important topic of inflation in general, and I have concluded that inflation is extremely unlikely for a long period of time (anyone seen the Japanese CPI numbers for the last many years?).  I am definitely not gloating, as I have yet to short gold and I missed the huge trade in the long bond.

There are two reasons to own gold (absent any change in industrial demand).  Most of the advocates of investing in gold cite inflation, and I believe that I addressed that issue in the previous article, where I suggested that the historical link no longer makes sense (and inflation isn't happening anyway).  I will review this argument and share my thinking regarding the lack of potential for inflation.  The other reason is to hedge against the breakdown of society.  While I won't rule out mass chaos, it is probably unlikely.  I do believe, though, that we could see a big rise in crime and will be publishing shortly some thoughts on this subject.

In the 8 weeks since I published my first-ever comments on gold, it has fallen 10%.  I mentioned in that article that I believed that gold would be more appropriately priced at $600 or so.  It touched as low as $700 before rallying and then retreating again. 

The chart above for the SPDR Gold ETF (GLD), which is designed to replicate the price of gold bullion,  shows the recent decline.  Note that the consecutive highs have been lower, while the lows have as well.  Additionally, the moving averages have rolled over.  Technically, gold looks like every other asset:  sick.  I included the bottom panel because I wanted to highlight the radical change of late in the Treasury market.  Longer-dated bonds have seen yields plunge, a sign of a massive shift in investor sentiment.  Rates on the short-end have obviously diminished due to Fed policy and an extreme flight to safety, but this recent sharp decline in longer yields has come during a time of stock market stability (though commodities have plunged subsequently).  The decline in yields appears to reflect investor sentiment regarding inflation.  While gold has fallen "just" 10%, oil has continued to plunge, falling almost 50% since the October article.  The CRB, more broadly representative of commodities, has dropped an astounding 28% in those 8 weeks.  It would seem that the market is not telling but yelling that inflation is not a threat but rather quite the opposite.  While gold has been doing "relatively" better, if you hold gold, it's time to fold.  Here's why:  Supply and demand.

On the supply side, I expect to hear about central bank liquidations eventually.  According to the World Gold Council, the U.S. has about 8000 metric tons of gold.  This may sound like a lot, but at $750 oz, this is "only" $211 billion.  According to that same source, the U.S. is anomalous in that it holds over 70% of its reserves in gold compared to foreign currency.  The total amount held by central banks and the IMF is approximately 29,000 metric tons, or about 20% of all gold.  After the U.S., the largest holder, Germany, France, the IMF, Italy and Switzerland own a combined 12,500 metric tons.  They tend to have over 50% of their forex reserves in gold.  The general trend in other countries has been to more aggressively diminish the role of gold.  The UK, for instance, owns only 310 metric tons representing just 10%.  While I am no expert in central banking policy, it would seem politically that converting gold to cash would be feasible in this environment.  To put things into perspective, if the central banks decided to decrease gold by 10% (2900 tons), the dollar value would be $76 billion, which amounts to 4X the amount of assets held by GLD.  With all of the turmoil around the globe, would it be surprising to see some central bank sales of gold?

On the demand side, Joe Retail has been paying up big for tangible gold.  There is a lag - it takes time to produce physical gold.  The conspiracy theorists read a lot into this, suggesting that someone is "artificially keeping gold down".  As commodity prices continue to fall, I believe that that many who have made the bet could actually reverse it.  I would argue that rather than a conspiracy theory keeping "paper gold" artificially low, it is this irrational demand for "physical gold" that has prevented it from collapsing even further.  As I mentioned in the original article, almost every commodity or "store of value" is plunging, and it has gotten worse.  Art auctions are indicating year-over-year declines of 50% or more recently.  Gold bugs like to argue that gold is a "currency", but please tell me where I can use gold to buy things.  In the days of nomads crossing borders, gold was a currency, but it no longer serves that role anywhere from what I can tell. 

The most compelling reason for demand to fade is that the debate will soon shift from "deflation or inflation" to just "how much deflation".  I had been struggling conceptually with what the response will be to the massive measures being undertaken by the Treasury and the Federal Reserve, but it became clear to me today as I read the words of someone who is in stark disagreement with my views.  The government is not printing money right now.  Simplistically, it may seem like "Helicopter Ben" is dropping bags of cash into the parking lots at the malls, but that isn't the case at all.  We are simply replacing private capital with public capital, which isn't in and of itself inflationary.  We are increasing federal debt but increasing equity in the financial system.  We are shifting the leverage from the private sector to the public sector.  The cost ultimately will be higher taxes at a minimum.  This could lead to lower economic growth and also potentially higher interest rates.  We do run the risk of inflation if we keep interest rates too low after the crisis has passed, but worrying about that challenge now seems extremely premature.  Consider the Japanese example, as it seems very analagous to ours.  Short-term rates have been low there for quite some time, but there hasn't been any sign of inflation.  I believe that ultimately we will come to view the commodity rise that included gold and oil as just the last of the speculative bubbles and will wonder why it took so long for gold to roll over and die.  I will slightly alter my prior conclusion and say that if you are considering gold as an inflation hedge, you should take a look around you.  If you still are concerned about inflation, learn about Treasury Inflation Protection Securities (TIPS). Gold remains a sucker's bet... 

Disclosure:  No position in gold or any derivative

Review of Sramana Mitra's "Entrepreneur Journeys"

Many of you may already be familiar with Sramana Mitra through her Seeking Alpha contributions or perhaps her columns in Forbes.  I have enjoyed her perspectives in those venues, so I am not surprised that I found her first book, Entrepreneur Journeys, to be so captivating.  I liked it so much that I sent it to all of my clients as a year-end gift.

The book is a collection of interviews with entrepreneurs organized into five sections:  Bootstrapping, Taking on Giants, Disrupting Business Models, Addressing Unmet Market Needs and Tackling Planet Scale Problems.  In all, she interviews 12 dynamic entrepreneurs.  I think that one of the things I liked best about the book is that it is so optimistic - several of these leaders overcame what seemed to be insurmountable odds.  With the financial markets in disarray, several of these vignettes inspired me to see past the current gloom.

I recall reading Michael Lewis' "Liar's Poker" when he published it almost 20 years ago.  At the time, I actually worked in the world that he depicted and knew several of the "characters".  I felt that Sramana serves as a similar type of insider in the world of venture capital who is able to really hone in on the essence of the culture.  When I read these interviews, I felt like I was overhearing an intimate conversation.  As an equity analyst, I certainly appreciated that Sramana asked the right questions, which got right to the crux of the issues at hand. 

I was familiar with some of the ventures featured in the book, certainly the public ones, but the breadth and global nature of her subject fascinated me.  Crunching numbers and trying to spot trends is what many of us do as analysts or investors, but trying to capitalize on the somewhat abstract concept of "management quality" is something that I believe sets apart the pedestrian analyst from the valuable one.  This book really helps the reader to appreciate the qualities of a leader who plans for the long-term but navigates through the challenges of the short-term.

Sramana covers the bases with respect to pre-bubble and post-bubble entities.  She leads of with one of the most interesting interviews of all, Jerry Rawls of Finisar (FNSR).  After a meteoric rise during the bubble, the business almost evaporated, but Rawls took the steps necessary to keep the company alive.  The other "bootstrapper", Sridhar Vembu of AdventNet, is taking on Salesforce.com (CRM) with 600 engineers in India, 6X the number of engineers at his rival. 

The "taking on giants" section leads with Steve Hafner of Kayak.  Hafner started Orbitz (OWW) and started Kayak to fulfill the original mission he felt Orbitz failed to ultimately address.  The next entrepreneur, Gautam Godhwani of SimplyHired, tells how he has used technology to differentiate and to become the number 5 player rapidly in a highly competitive job search market.  Finally, Russ Fradin shares how Adify is taking on Google (GOOG) in the online advertising space.  Any investor should appreciate the threat of competition after reading these dialogues.

The next section ("disrupting business models") features a company out to be the "next VMware" (VMW), Qualys, as well as one of my favorite interviews with Steve Singh of Concur (CNQR).  The CEO of Qualys, Phillipe Cuortot, has so much experience with big blundering companies that he can't help but succeed outside of them.  Singh discusses the challenges of distributing product to customers across the entire spectrum with respect to size. 

The next section ("addressing unmet market needs") features a fascinating interview with the young Stanford MBA, Marcos Galperin, who created a Latin American "Ebay", MercadoLibre (MELI).  My wife is a teacher, so I was very excited about the interview with HotChalk founder Edward Fields.  Anyone interested in learning about how technology can be applied to make education work better should read this interview. 

Finally, Sramana concludes with three entrepreneurs trying to solve major global problems.  Energy Recovery Inc. (ERII), which just went public this year but has been around for decades, uses reverse osmosis to create energy.  Obopay has created the infrastructure for micro-finance in developing countries (using mobile phones).  SELCO provides solar panels to poor workers in rural India.  It is this last section that really leaves the reader optimistic that we humans will ultimately overcome any obstacle.

I really enjoyed learning about the people behind these enterprises and what makes them tick.  Sramana does a great job of placing everything in context.  She links their past efforts and weighs their successes and their challenges in both their present endeavors as well as past ventures, all seemingly with the goal of understanding the factors that can lead to success.

This book was an easy read, as it isn't technical at all and could appeal even to someone without a background in business or finance, especially the final part highlighting entrepreneurs tackling major social issues.  Given that it is essentially a collection of short stories, it is a great book for the busy reader who has to cram in time for reading.  Good luck putting it down!

Disclosure:  I have no positions in any stock mentioned in this book review